Federal Program Overcharging Some Repaying Student Loans

Three years ago, Congress set out to ease the burden of repaying federal student loans by creating a program that capped monthly payments at a certain percentage of take-home pay.

That program hasn't helped Julie Zumas, a public health worker in of Bethlehem, Pa., struggling under $60,000 in federal student loan debt. The 33-year-old signed up for the Department of Education's Direct Loan consolidation program in November in order to qualify for income-based repayment. As part of the application she gave authorities access to her tax returns and a recent pay stub. (For background reading, see Should You Consolidate Your Student Loans?)

When she learned that she had been approved a week later, Zumas was shocked to discover that her monthly payment had somehow doubled from the $200 she'd been sending Citibank (NYSE:C) each month under the standard repayment terms.

What happened? It appears that ACS Education Solutions, the private company that collects payments for the Department of Education's Direct Loan program, based Zumas' repayments on her gross income, rather than her adjusted gross income, as Congress intended.

Often, the difference between gross income and adjusted gross income comes down to little more than a rounding error. In Zumas' case, it mattered a lot: Her gross income in 2009 was $49,000, but her adjusted gross income, which strips out certain tax deductions, was only $23,000. If ACS had correctly used her adjusted gross income, Zumas' monthly bills would only come to $85, instead of the $400 it charged her.

ACS, which is now a part of Xerox (NYSE:XRX), referred all questions for this story to the Department of Education. The company has been servicing loans under the Direct Loan program since 2003 under a $2 billion contract. Its compensation is not based on amounts borrowers repay, according to a Department of Education spokesman.

A department spokesman admitted that the government is aware of the problem but declined to disclose how many borrowers in the Direct Loan program are being overcharged. Borrowers who pay more than required under income-based repayment will have the extra amount applied to their principal.

Forbes heard from more than a dozen borrowers with similar tales, including an attorney who now works with the Internal Revenue Service whose gross income was $25,000 more than her adjusted gross income. Each said that they believed that the ACS customer service reps they spoke with didn't know the difference between gross and adjusted gross income. Some were told that there was no way to challenge the company's payment calculation until they filed their 2010 tax returns next year.

In each case the borrower was told that his or her payments were based on recent pay stubs, rather than income tax forms.

Overpayment of most loans comes with a silver lining: extra amounts paid up front reduce the principal faster and lead to fewer interest charges. However, many borrowers in the income-based repayment program are attracted by a provision that forgives any balance remaining after 10 years for anyone working in public service, and 20 years for those that work in the private sector. A police officer in income-based repayment who overpays his loans by $100 a month could end up making $12,000 in unnecessary payments by the time his loans are forgiven 10 years later.

Delays in processing the correct repayment amount can cost borrowers in other ways, too. A tax attorney in the income-based repayment program who requested anonymity says she spent five months trying to get her monthly bills based on her adjusted gross income. By the time the problem was resolved, $2,500 in new interest charges had accrued on top of the $156,000 she already owed.

Two days after being contacted by Forbes regarding this story, the Department of Education announced that it was planning on sending a bulletin to all ACS employees explaining adjusted gross income and informing them that future repayments should not be calculated based on borrowers' pay stubs, which reflect gross income only.

For those in the income-based repayment program, or applying for it, it is important to make sure your loan servicer has calculated your bills correctly. This is easy to do with your most recent tax return. Your adjusted gross income will appear on line 4 if you filed a 1040EZ, on line 21 if you filed a 1040A and on line 37 if you filed a 1040.

Unmarried individuals with no children should subtract $16,245 from their adjusted gross income, and then divide that total by 12. You will owe 15% of that amount every month.

The amount that you are able to subtract from your adjusted gross income increases with family size. A married person with two children, for example, would subtract $33,075 from his adjusted gross income, and then follow the same calculation.